Imagine that it’s 2013, and the world has entered a deep recession in the wake of a renewed sovereign debt crisis in Europe and another wave of mortgage bond defaults. “New Jefferson Bank,” with over $1 trillion of assets, is nearing collapse after its secured creditors, recognizing the bank is highly exposed to failing assets, yank their short-term deposits.
The Treasury Secretary calls an emergency weekend meeting of the Financial Stability Oversight Council, which brings together the heads of the government’s financial regulatory agencies. By Sunday night, they must decide what will be done to avert a wider panic on Monday morning. A failure to act could bring down the entire financial system, and lead to a global depression.
How will those bank regulators respond to that future crisis under the Dodd-Frank financial services law passed in 2010? Some of the nation’s leading economists, regulators and financial experts – including former Treasury Secretary Lawrence Summers -- gathered in a room in New York recently for a full blown simulation to find out whether the law would achieve its stated goal of preventing a full-blown financial crisis.
In 2008, there appeared to be only one option for government officials and regulators faced with a similar situation. Either let the banks fail – as officials did with Lehman Brothers – or run to Congress for a bailout. Then-Treasury Secretary Henry Paulson eventually did both. While it took Congress two votes to finally pass it, the $700 billion Toxic Assets Relief Program (TARP) successfully halted the panic. It did so by guaranteeing the loans of the unsecured creditors at institutions that had frittered the money away on sub-prime mortgage bonds and failed derivatives trades.
At its heart, the Dodd-Frank financial overhaul legislation, named after its chief sponsors former Sen. Chris Dodd, D-Conn., and Rep. Barney Frank, D-Mass., gave federal regulators new powers to deal with similar situations in the future.
While prohibiting bailouts, the government now has the power to seize large financial holding companies that are on the verge of bankruptcy. The hypothetical “New Jefferson,” for example, is about half the size of Bank of America. Those “resolution” powers, which the Federal Deposit Insurance Corporation has held over individual deposit-taking banks since the 1930s, didn’t exist when Bear Stearns, Lehman Brothers and AIG collapsed, which led to widespread market panic and the freezing up of virtually all credit markets.
For many critics, like former International Monetary Fund chief economist Simon Johnson of the Massachusetts Institute of Technology, allowing behemoth financial institutions to continue to exist, even if there are rules for restructuring those that fail, is the central flaw in the Dodd-Frank bill. “The resolution powers won’t work for the largest cross-border banks,” Johnson wrote recently on Bloomberg View. “And bankruptcy for financial institutions would seriously undermine confidence, as happened with Lehman.”
Can FDIC-style restructurings work for huge financial services companies with large cross-border operations? Their complex financial dealings usually include exotic derivatives, off-balance-sheet two-party transactions and large inventories of questionable bonds produced by their investment banking arms. The Bipartisan Policy Center, at a forum sponsored by The Economist magazine, recently brought together an all-star cast of former government officials and leading lawyers and consultants to play out how they would deal with the failing New Jefferson under Dodd-Frank’s rules.
Summers, the Harvard economics professor, assumed his former role as Treasury Secretary. The Brookings Institution’s Donald Kohn, who spent 40 years at the Federal Reserve, played the chief of the central bank. BlackRock’s Peter Fisher, who spent 15 years at the New York Fed and was an undersecretary of Treasury in the early 2000s, took on the New York Fed chief’s role. Diana Farrell of McKinsey & Co., who previously worked for Goldman Sachs, advised the president. Rodgin Cohen, the managing partner of Sullivan & Cromwell and one of the nation’s top banking lawyers, advised the Treasury Secretary. And Covington & Burling’s John Dugan, former Comptroller of the Currency, spoke on behalf of the Federal Deposit Insurance Corporation.
The first option on the table was throwing New Jefferson into bankruptcy, which is the option usually favored by market fundamentalists. “There’s the 'Lehman was really fun so let’s repeat that' strategy,” Summers offered in a tone that suggested the answer was obvious. The panelists agreed and unanimously rejected that option.